FUND Q+A: Present sees flexibility in ETF investing

NEW YORK With exchange-traded funds overrunning the marketplace, Howard Present believes a strategy built around ETFs will help investors enjoy the fruits of a bull market while minimizing the pain of a bear market.

Present, president of Wellesley, Massachusetts-based F-Squared Investments and manager of the Virtus Premium AlphaSector Fund, uses a model composed of the 9 sector SPDR ETFs along with an ETF for cash.

The fund equal-weights each ETF, moving completely into or out of each sector depending on the group's outlook. Present says this helps the fund keep pace with market upswings without exposure to significant risk in a slumping market.

The fund gained 15.5 percent from its launch on July 1 to November 30, versus the 14.9 percent gain in the S&P 500.

Q: This fund is primarily composed of ETFs? A: It's exclusively ETFs. Most managers have been around chasing performance in one format or another. Philosophically this strategy is instead about managing risk. Increasingly, as can be shown by the growth rate that is coming into the mutual fund, and more broadly, my firm, the need to manage risk is becoming a higher and higher perceived need and investment destination. To put it in perspective, the mutual fund was launched with $1 million in July 2010 and it has $275 million today.

Q: Is that just a function of ETFs becoming more prominent as people pay more attention to them? A: Not at all. ETFs are a convenience for us. The success of the strategy and the commercial success and the performance success to date has nothing to do with ETFs. It's about the ability to change the way in which value is created for investors.

This is the strategy that has been designed to participate and hopefully outperform when the market is heading up. So if you are in a bull market, the goal is to give you full equity exposure. When the market goes into a weak phase, a bear market, the purpose is to manage risk and begin reducing exposure to the market in those down markets. Clients are interested in being invested in the market, they are interested in participating when the market goes up. But 2008 proved you just can't fully participate when the market goes down, you just can't give it all back.

Every decision we make is designed to avoid losses, which is very different than the normal model. So we are more risk focused than valuation focused. So every decision is designed to avoid losses, and in a bear market where there is really no safe haven we have the ability to go to cash.

Q: Which sectors are you invested in? A: The nine sector SPDRs, plus an ETF that will track our version of cash, which is 1- to 3-month T-bills. So there are ten ETFs we can invest in. If based on our analysis, and everything we do is quantitative, we feel that a factor has a higher probability of losing money than it does of making money, we eliminate exposure to the sector entirely.

Q: Wouldn't that cap your gains in a bull market? A: Today we have all 9 sectors active, so that means all 9 sectors have a higher probability of a positive return going forward. So we own all 9 sectors and we equal-weight them. We are likely to track the S&P plus or minus because we have 9 sectors active in the S&P today. For one week, right at the inception of the fund, 7 of the 9 sectors were negative for us, so they had a higher potential loss, so they were eliminated from the portfolio. So for that one week we only had two sectors active and a 50 percent cash weighting. For the month of July, though, we ended up turning on a couple of more sectors, so we probably average 5 sectors active for the month of July. July was a good month for the S&P, it was up about 7 percent, but because we didn't own healthcare, we didn't own energy, and a couple of other sectors that were lagging in that month, the strategy actually outperformed the S&P during the month of July.

Q: Some have attributed ETFs as being partially responsible for the flash crash on May 6th, do you have any concerns about that? A: We are very concerned about the integrity of ETFs and the liquidity of ETFs. The fact is we are very careful when we select an ETF to make sure that it meets a number of screens for us. One of the reasons we like the Sector SPDR ETFs is they have been around since 1988 and they are also the largest Sector ETFs in the industry -- they are far and away the most liquid. We are very comfortable that some of those concerns you raised are really not applicable to our portfolio.